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March 26, 2014

Why AUM Fees Still Make (Im)Perfect Sense

Back in the mid-1980s, a prominent financial planner (whose name escapes me) used to call it “the dirty little secret of financial planning.” He was referring to the fact that financial planners almost never got paid for doing financial planning—an observation that is still true today.

The first “financial planners” were commission-paid mutual fund salesmen (there weren’t any no-load funds back then). Then, when the stock market tanked and tax rates skyrocketed in the late 1970s, financial planners sold tax shelters. When the tax laws changed in the mid ‘80s, most planners switched to selling annuities, which remained the product du jour until the stock market rally turned into a bona fide bull market and managing mutual funds in allocated portfolios for a fee finally took the “sales” out of financial planning (not that there’s anything wrong with that).

Or so I thought. Until I had a conversation the other day with a prominent financial planner who, shall we say, is not a fan of AUM fees. “Just another form of commissions,” she called them, citing the conflicts that arise when a client might benefit from taking part of their investment portfolio and paying off their mortgage, and that holding some assets, such as bonds to maturity, certainly doesn’t warrant a “management” fee. She went on to suggest that instead of the current, flawed fee compensation model, leading financial planners today are shifting to the far more client-centered flat annual fees for financial planning.

Even though she was advocating an expanded version of financial planning—that goes even beyond George Kinder’s Life Planning—to include applying the latest research on behavioral economics and client communications, I have to admit that I did not react well to her “attack” on AUM fees.

Being ancient enough to have experienced those days when many financial planners were salespeople (again, not that there’s anything wrong with that), I have a reverence for the transformation of retail financial advice prompted by AUM fees. In my view, AUM fees have taken independent advice to the next level, in four important ways:

1) AUM Fees Solidify a Fiduciary Standard for Retail Advice-GiversThere is no substitute for a legal duty to put the clients’ interests first. Even though many advisors, particularly some brokers and CFPs, consider themselves only part-time fiduciaries for each client, it’s had a dramatic effect on all financial advice, as more and more clients are asking why they aren’t their fiduciaries all the time. Even SIFMA is slowing acquiescing to a full-time standard.

2) AUM Fees Put Advisors (Mostly) on the Client’s Side of the TableYes, AUM fees still have some conflicts, most notably the two mentioned above, and the advisor’s fee itself. Of course, this conflict exists with every transaction where one person pays another person for a service. With access to information, such as the Internet, people can check the going rates and make good decisions. We already see this happening. More importantly, advisors get paid more only when client’s portfolio grow. Is that perfect? No. But it’s waaaay better than the old days. I’ve been there.

3) AUM Fees Create Recurring Revenue Ongoing fees revolutionized the business model of financial advice. Rather than starting each year with zero revenue, and having to “sell” something to each client again or find new clients, fees allow revenues to compound, and to grow as client portfolios grow. What more, recurring fees have a marketable value: within the past 20 years, a market has emerged to buy and sell advisory firms, in many cases for millions of dollars.

4) AUM Fees Enable IndependenceTo my mind, this is the most important benefit of fees: for both advisors and their clients. AUM fees paid directly by the clients mean that their advisors are not financially beholden to any other firm. Even custodians are replaceable, as we’ve seen in the trend for advisors working with multiple custodians to get the right service/product/cost level for each client. Even advisors who still work through a broker-dealer enjoy a much higher degree of independence (and payouts) than ever, as their BDs are well aware of the ease with which they could move to a custodian. While independent advisors aren’t conflict free, they have far fewer conflicts than their wire house counterparts.

Taken together, these effects of charging AUM fees have made independent advice today’s "go to" business model. It's why many brokers are leaving wirehouses, and why a fiduciary standard for brokers is under discussion. In fairness, these advantages would apply to flat financial planning fees, too, with the exception of sharing in the clients’ financial success, and growing revenues when the market goes up. (Of course, they avoid losing revenues when the market goes down.)

The biggest problem with flat financial planning fees is that many planners have tried them over the past 40 years with very limited success. Occasionally, we’ve seen some advisors who’ve made them work, most notably those in the Garrett Planning Network, who charge their clients by the hour. The problem is that there’s a limit to how much they charge per hour and how many hours a week they can work: plug in your own figures and do the math—it’s not pretty.

Would it be better if financial planners charged their clients a flat fee every quarter? From a conflict standpoint: probably. And it would be nice if financial planners finally got paid to do financial planning. Is it a viable business model on a large scale: Probably not. Historically, clients have had a hard time paying for financial planning just once. Asking them to pay for it year after year, when their financial plan remains essentially the same, has always been a very hard sell.

Growing client assets is the engine that drives any financial plan. That’s why it makes more sense to clients—and for advisors—to charge for growing those assets, and to provide financial planning to use those gains to reach their clients’ life goals.